As the investment landscape continues to shift, active fixed income offers investors many ways to seize attractive opportunities in 2023 – while mitigating risks. In the following Q&A, PIMCO Group CIO, Dan Ivascyn, discusses.
Q: Markets expect the Federal Reserve may soon pause its rate hikes and perhaps even begin cutting later this year. Some forecasters are calling for recession and yet U.S. unemployment just hit 50-year lows, and stocks and bond markets are rallying. How does PIMCO’s investment process help us make sense of all of these signals and provide a framework for investing in today’s markets?
A: It’s certainly an uncertain macro environment, and we’ve been spending a lot of time at the investment committee at our quarterly cyclical forums talking about the outlook for growth, inflation, and of course by extension, central bank policy.
So we are more constructive in the base case, and the data has been favorable towards inflation declining and economic momentum being maintained. With that said, there’s massive macro uncertainty, massive geopolitical uncertainty. We still have an inflation dynamic that’s been very, very challenging to understand.
On the growth side, given inevitable lags in terms of central bank policy actions to date, there is a real risk of a hard landing, and that hard landing probability could go up a lot if the geopolitical situation were to deteriorate.
For so many years, central banks have suppressed volatility. With central banks at best pausing policy tightening, you no longer have that natural volatility suppression mechanism.
At the economic level, much less synchronized growth cycles. I think you’re seeing that today with China coming out of a Covid period where we’re seeing growth actually accelerate, whereas in the rest of the world, although the data’s been more mixed recently, there’s some signs of economic slowing.
It’s always dangerous to invest on a base case type scenario. But I think in this environment, with very, very fat tails on both ends of the distribution, it’s particularly dangerous. So in addition to our typical economic process, we’re doing a lot of scenario analysis, we’re looking at how portfolios are going to perform in the respective tails. But given the ugly nature of those tails, we’re willing to exchange a little bit of base case return, a little bit of base case yield for some of that structural resiliency.
Bonds tend to provide attractive qualities when you see significant economic deterioration, and there’s a risk of further economic deterioration relative to expectations.
As we move forward in the year, if we see perhaps a shift in valuations where the market begins to discount a higher probability of some of these tail scenarios, we’ll be ready to go on the offense. We look to embed a lot of portfolio flexibility into our various strategies. And we do think there will be a time, perhaps, in the future, where we are going to be a bit more aggressive in some of those more economically sensitive areas of the market.
Q: PIMCO’s last cyclical outlook discussed that bonds are back after last year’s surge in yields restored value in fixed income. Bond markets have rallied somewhat in 2023, so how do you think about timing of entry in terms of investing in fixed income markets? And where are you seeing value across specific sectors of the bond market?
A: We’ve had a bit of a rally, and we think, again, given our fundamental outlook for fixed income, valuations look pretty attractive. We do think investors that have been on the sidelines should continue to return to the market. You can potentially generate returns in the 5%, 6%, 7%, even greater range in a relatively high quality fixed income portfolio.
The absolute level of interest rates is up at levels, particularly in the front of the curve, that we haven’t seen for many, many years. When you look at segments of the market that provide you with inflation protection, real yields or inflation adjusted yields look quite attractive today and in fact are still at levels that we haven’t seen since really around the last global financial crisis.
So pretty good value in terms of the rate markets in general, both absolute and relative to equities. When you talk about the spread sectors, it requires a bit more nuance. The prospects for a softer landing have increased. In fact, our base case outlook for economic growth this year is somewhere near the zero level.
Our probabilities of recession right now are something around 50-50, with the view, again, in the base case that any type of slowdown would be fairly shallow in nature. The one big caveat is that anytime you’re talking about stall speed type growth, the economy’s susceptible to negative growth shocks or simply being a bit too optimistic in our forecasts.
So what we’re trying to do from an asset allocation perspective is to take advantage of this massive rise in yields, widening of spreads, but still focus on areas that are less economically sensitive that will do well in our base case but prove to be quite resilient even if we’re wrong and we got into a situation where the economy was in far greater stress.
So we like high quality risk. We like opportunities in the structured products markets, legacy mortgages, asset backed, commercial mortgages that typically benefit from a solid investment grade, even AAA rating. We really like agency mortgage backed securities. Looking outside the United States, I know it’s been a while since we’ve seen a sustained period of dollar weakness, we do think that foreign investments, an allocation of foreign currencies, will likely to continue to pay dividends.
Over a multiyear period, that opportunity set outside the United States, both in the developed markets and segments of the EM markets, look attractive as well, both on the fixed income and the equity side.
We continue to think that investors at least in the mark-to-market segments of their portfolio should be a little bit cautious about senior secured loans, other types of floating rate corporate debt. Those corporations are feeling the full brunt of central bank policy.
Stay up in quality and be more aggressive in taking advantage of the widening we’ve seen in some of those more resilient, less economically sensitive areas of the market, still be a little bit more cautious in the weaker segments of the market, especially given a pretty considerable rally that we’ve seen year to date.
Q: We saw public markets reprice significantly in 2022, but yet this wasn’t reflected on the private side. How do you expect that dynamic might evolve in 2023, and can you discuss how investors should think about value across public and private markets?
A: Sure. You know, public markets always tend to move first, and because we had such a massive move in rates and in equity markets, they moved a lot.
Private markets tend to be slow to move, and because of the big move in public markets, that gap is about as wide as we’ve seen throughout our career. That gap will converge over time. It could converge by private marks catching up to their public counterparts. It could converge by public markets rallying back to the private levels. Or more likely, a little bit of both.
Given the big move we’ve seen in public markets, the lagging nature of private markets, people should be looking to deploy capital today with a tilt towards the public market. That being said, we think there are going to be tremendous opportunities within the private opportunity set, particularly for patient investors. There’s been such a violent move in yields, in spreads, in public equity markets, in various areas of the private equity markets, VC, growth equity, that it’s going to lead to strain and stress that’s going to develop over time.
We’re going to go through a cycle that’s going to require new capital, with good companies that have over levered capital structures needing to adjust to this new economic reality.
So even though the opportunity is significantly tilted in favor of public markets today, investors should really, really think about setting up for what’s going to be a pretty darn attractive opportunity, and we think there’s a chance that that opportunity could last for several years.
